The future of offshore financial centres:

Domestic policy frameworks matter

If you were to carry out a survey of the articles published by pro offshore writers, you would very likely find that the vast majority of them either blame external factors for the challenges faced by OFCs or place these external factors at the heart of their success.

This is not without basis; there are many such factors ranging from onshore legislation which creates the need to go offshore, to increased demand from emerging markets such as Asia, to the usual pressures from multilateral bodies such as the OECD, IMF etc.

That said, aside from discussions on matters such as the beneficial legislation offshore or access to professional infrastructure, very little is discussed regarding the domestic policy framework in OFCs and how that may impact the future sustainability of these financial centres.

But domestic policies matter. Immensely. Consider, for example, that the Cayman Islands benefited (some would say greatly) in its own launch as an offshore centre from political instability in the Bahamas in the 1970s, resulting in many Bahamian based banks switching their operational domicile to the Cayman Islands during those years.

The Cayman Islands became one of the largest offshore banking domiciles literally overnight. It has been said that if one were to compare the banking registries in the Bahamas before the crisis to that of the Cayman Islands afterwards you would see literally the identical list with the only difference being the “(Cayman)” after the company name. It has taken the Bahamas over three decades to recover from that error in their domestic framework.

What governments do politically and economically has always meant a lot to potential and existing investors and that principle applies offshore as much as anywhere else.

What does it mean to have an OFC brand?

OFCs are used by international clients for obvious commercial benefits. But these benefits are also accompanied by a basic trust held by clients that the jurisdictions will maintain good governance, essential property rights and continue to display general economic and political stability. These attributes are an important part of an OFC’s brand. A fund manager in New York will have no success raising capital for a hedge fund domiciled in a war torn zone.

Likewise a client will not domicile a private trust company in a country where there is no respect for property rights.

The stock placed in an OFC is similar to the goodwill that investors have towards holding US dollars, for example. This is a trust that is based almost entirely on the perception that the US government is strong/stable and less on true economic fundamentals which may or may not support the US dollar itself.

OFCs that maintain a stable environment which provides support for the industry, while displaying good governance, property rights and fiscal stability will be more likely to continue to attract clients than those that do not because the essence of their brand (a stable domestic environment) remains intact.

Economic challenges

Since the global economic downturn of 2008, one of the greatest challenges for many OFCs is economic and in particular the fiscal difficulties faced by governments. A government faced with balancing its annual budget will be tempted, for example, to turn to its financial services industry to secure the additional revenues. This can potentially have a negative impact on the competitiveness of that jurisdiction.

Another example is a government that experiences a significant downgrade in its sovereign ratings as a result of perceived economic instability. Again this can negatively impact a client’s perception of the benefits of using a vehicle incorporated or serviced in that jurisdiction. In finance a sovereign rating impacts the ratings of major vehicles and operational entities domiciled in that jurisdiction, irrespective of whether this link is real or perceived.

Other domestic economic challenges such as high unemployment can also lead to unintended consequences in OFCs. Under these circumstances, domestic pressures may be placed on local politicians to introduce an arbitrary, as opposed to a market led, rebalancing of employment towards locals and away from imported high skilled workers. This can obviously have a negative impact on client services and may even result in some firms switching to another jurisdiction to be able to operate more efficiently.

All of these domestic economic and financial challenges can squeeze OFCs into making poor decisions which do not bode well for the success of the industry. The key to managing this challenge is knowing where to strike the balance. An OFC that chooses to go for the short term benefit of securing increased revenues for the purpose of a balanced budget for example, could be faced with a significant reduction in the size of an industry which employs many locals in say two to three years (once the firms have had time to adjust and switch to another jurisdiction).

The OFC ‘menu’ effect

There is enough anecdotal evidence to suggest that some OFCs have taken the view that global financial services firms need the jurisdiction more than the jurisdiction needs them. This way of looking at things stems from the traditional advantages offered by OFCs; be it more business friendly regulation or a tax neutral platform. It is also coupled with the view (which bears out in experience over the years) that the main onshore centres, for a variety of reasons, are not in a position to offer these attributes easily, if at all.

But with the proliferation of competing OFCs and the increased global footprint of financial services firms operating in the OFC space, the negotiation position of local governments in OFCs has weakened significantly. Global firms now have options: if one jurisdiction is considered too expensive, they can switch their clients to another. If one OFC is perceived to have unfriendly regulation they will simply redomicile the respective vehicle in another and so on.

Firms with multi-jurisdictional presence are in some ways similar to a restaurant with different items on its menu; a BVI company for some clients, a Cayman hedge fund for others, an Isle of Man trust company due to time zone issues, or a fund admin team based in Halifax, because it may be provided at a higher quality and cheaper costs for certain types of clients.

The leverage that OFCs have in today’s climate is therefore considerably less than what they may have had two decades ago when the ‘restaurant’ had only one jurisdiction/product on its menu for clients. This places increased pressure on OFC governments to do a much better job of knowing how to balance courting their existing industry while addressing domestic needs. Those that are better at managing this menu effect will have a higher chance of survival than those that continue to over-estimate their position of leverage.

A truly business friendly way forward

For OFCs that are seeking to not just survive but thrive for the next two decades, being business friendly means much more than having the right regulatory balance or protecting their tax neutral/low tax platform. It also means ensuring that their domestic policies are not only supportive of the financial services industry but also directly encourages its success. Clients that utilise offshore financial services have always been relatively sophisticated, but they are now also well aware of the options available if their current jurisdiction of choice becomes unstable economically or politically. Importantly they also know that this poses a risk to the benefits they derive offshore. OFCS looking to survive in the new era should bear that in mind.

Paul Byles is owner and Director of FTS, which provided regulatory, economic and management consulting services. He is an experienced economist and finance professional having worked in the financial services industry for 25 years. He is a former director of a big four consulting firm and a former Head of Policy at the Cayman Islands Monetary Authority. He is author of the book ‘Inside Offshore’ which focuses on the reputation of the Cayman Islands as a financial services jurisdiction and author of ‘Offshore Financial Services: a BVI text’, published in 2014. He serves as an independent director on a number of financial services and local operating firms. He is currently President Elect of the Cayman Islands Chamber of Commerce, having served on its council since 2014.